The purpose of insurance is to transfer to an insurer the
policyholder's risk of suffering a monetary loss should an unpredictable event
happen. For example, fire insurance protects you from a large monetary loss
should your house burn down. Insurance companies are able to provide such a
service by correctly estimating the chances of such an accident happening and charging
each customer an amount that is equal to the expected loss from an accident.

The expected loss is equal to the probability that a loss
will occur times the cost of the loss. For example, if there is a 1 percent
chance that your house will burn down during the year, and it will cost
$100,000 if it does burn down, then the expected loss is equal to 1 percent of
$100,000, or $1,000 per year. Most people are risk-averse and therefore will
purchase insurance even if the premium is a little more than the expected loss,
rather than self-insure or take on the risk themselves. This is generally the
case because individuals cannot easily spread the risk of the loss on their
own. While the chance of your house burning down is small, if it does you may
not be able to replace it, so you buy insurance.

Insurance companies earn a profit by spreading the risk and
charging a little more than the expected loss. If an insurer has 1 million
customers, then it can expect that a large number of houses will burn down, but
if it has calculated the risk correctly, then it can expect to have enough
money from premiums to make the payments.

Stay Engaged

Receive our weekly emails!

email address

Insurers may charge premiums that are less than the expected
loss if they can invest the premiums and the losses occur much later. Insurance
companies primarily invest in fixed-income securities, which have a return that
is generally less than the equity market, but carry much less risk. (Bonds
still involve risk, including the solvency of the borrower and price volatility
if the bond cannot be held to maturity due to cash flow problems.) Because the
rate of return on investment is not risk-free, it is important that companies
correctly estimate the probability and cost of an accident.

For an insurance company to cover its costs, and thus
provide insurance in the first place, it must use whatever information it has
available to help it better calculate expected losses from accidents-not only
for its entire customer base, but also for smaller groups within its customer base
that have different expected losses. For example, suppose that we know that
people who have accumulated speeding tickets are more likely than drivers who
have not received a ticket to have an accident. Successful insurance companies
will use this information when setting premiums that are sufficient to cover their
expected costs.

Conversely, were government policies to preclude auto
insurers from using this information, then the insurers will take on more risk
than they would otherwise have to, and would have to charge higher premiums for
everybody. Such policies make it more expensive to provide insurance, and thus
lead to higher premiums and encourage those who have low income, low expected
losses, or both, to avoid purchasing insurance.

Another way to raise insurance premiums is to require
insurance companies to offer only policies that provide high amounts of
coverage. For example, if insurers could only sell fire insurance policies that
had no deductible, they would have to charge much higher premiums in order to stay
in business, since the loss to be covered would be greater than if the
individual policy holders had the option of paying a deductible.

An important consideration to keep in mind when discussing
insurance is the problem known as moral hazard. This is the problem that arises
when a person is insured against a specific risk and the security provided by
that insurance discourages him or her from taking optimal precautions against
incurring an accident. For instance, if you have car insurance, then you may be
less likely to drive as carefully as you would if you did not have insurance.
(In the automobile insurance market this is likely mitigated by the fact that a
car accident may cause physical damage or bodily injury that the driver may
wish to avoid even if he was compensated for the financial cost of the
accident.)

There is a related problem to moral hazard, which studies
have found to have a significant effect on insurance premiums — third party
payment. This problem particularly besets medical insurance. When an individual
suffers an injury and the insurance company must pay all — or nearly all — medical
costs, both the injured party and those who are delivering treatment will have
every incentive to choose very expensive treatments even if the added value of
those treatments is small. We have all seen the advertisement for the motorized
wheel chair that we are told is "free" to individuals covered by Medicare. With
a price of zero, people who have no idea what the cost of these wheelchairs
actually is will be more likely to demand them.

This encourages the use of very expensive treatments and
makes it difficult for insurance companies to figure out the expected loss from
an accident because the insurer's liability is not limited. As noted above, the
insurer must correctly estimate the probability and cost of an accident in
order to set a premium that allows it to stay in business. If the insurer does
not know what the liability will be then it will not be able to set premiums
with any degree of accuracy, and in order to protect itself from bankruptcy
will set premiums higher than if the liability were limited.